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Unlock the rewards of medical discovery

The long and the short of it is that healthcare stocks can offer long and short-term returns, writes Kristine Bryan

The fact that people are living longer, coupled with the need for more treatments for more diseases, makes healthcare one of the fastest growing industries in the developed world.

Medical companies are constantly trying to find new ways of administering established drugs in a more patient-friendly way. An example of this is the discovery of inhaled insulin by Pfizer, Inhale Therapeutics and Aventis, which should allow many diabetics to avoid or reduce the painful regime of having to inject themselves several times each day.

In addition, the fact that more people can now afford a wider range of medical care in the western world will accelerate growth in this industry. Around 25 years ago, the only treatment for ulcers was surgery, at a cost of $25,000 per patient. Nowadays, this can be treated with drugs costing as little as $1,000.

This strong growth potential means that investors in healthcare will be rewarded well in the long term. But healthcare investing offers the additional bonus that, in times of short-term uncertainty, it can provide a safe haven from volatility. As a result, healthcare shares rose strongly in 2000, a year in which many other long-term growth stocks fell sharply.

Economic cycles

Healthcare is one of the few industries that is relatively unaffected by economic cycles. People need medicines whether the economy is doing well or not. In countries where there is socialised medicine, the governments pay, and in developed countries where there is little or no subsidised healthcare, insurers generally pick up part of the bill.

We aim to find those companies that will be successful in meeting the strong growth in demand. These include companies with novel products. A novel product is not just a new product, but one for which there is no direct alternative.

For example, it could be a medicine for a condition for which no other medicines exist. Or it could be a completely new way of administering a drug or treatment. This includes the US pharmaceuticals group Alza's new product for Attention Deficit Disorder (ADD). The 'novel' aspect of this product is that it allows a single pill to be taken only once a day, which releases the correct dosage gradually throughout the day.

In addition, American Home Products has developed a novel immunosuppressive agent that reduces the risk of a patient's body rejecting a kidney transplant. Novel products can often be sold at premium prices because there is no comparable alternative.

Patents

Investors can also focus on companies that enjoy a dominant position in their own medical field, or those with a product for which demand has been underestimated by other investors.

An important area to watch, however, is patents and how long they have to run. On AstraZeneca's anti-ulcer drug Losec, for example, patents are due to expire later this year. This is likely to impact revenues in the short-term as competitors move into the same market. However, AstraZeneca has developed a successor drug that it claims is more effective and will be protected from competition by a patent for the first few years.

Researching research

The amount of money spent on research is another area to consider. The cost of researching, developing, and distributing new medical products is huge.

It is estimated that healthcare companies spent $28bn on research and development worldwide in the year 2000. Large pharmaceutical companies such as Pfizer are spending as much as $4bn a year on developing the treatments of tomorrow.

But the potential rewards far outweigh the costs. If the product is successful, a company can expect to make operating profits of 30% to 40% of the sales revenue.

When Warner Lambert produced Lipitor, a cholesterol-reducing drug, the impact on profits was amazing. The drug accounts for over half of total sales of a worldwide market worth $13bn a year. Also, companies can cut down on costs by embracing technological advances to control drug development costs. In addition, partnerships and mergers are helping to keep costs down.

Some investors assume that healthcare investing is about investing in biotechnology. But Schroders has maintained a relatively cautious stance to biotech, with less than 10% of the portfolio held in this area throughout much of last year. Schroders aims to provide investors with a broad exposure to a wide range of healthcare companies, without excessively exposing them to the higher risk and volatile biotech sector. In addition, unrealistic valuations among biotech companies led us to largely avoid them for much of the last year.

Having said this, Schroders is now beginning to find some attractive and reasonably valued opportunities in this sector. One is Adolor, a company that develops drugs that relieve pain and the side effects of other pain treatments. A number of its products are in late phase development.

But at least half of the company's portfolio is made up of large and established pharmaceutical companies.

While such companies provide a solid core to the portfolio, Schroders can also take advantage of the growth potential in a number of medium-sized and small-cap stocks.

One of the most successful of our smaller company holdings to date has been North American Scientific. The company makes radioactive seeds for brachytherapy, a treatment involving implanting radioactive material in cancer patients to target tumours. The stock has risen 70% since we first invested in it.

It takes times for drug companies to develop and manufacture a new drug and then get it accepted by the regulatory authorities. For example, American Home Products has suffered litigation issues relating to its diet drugs. But the company has the financial reserves to contain this risk, and, looking forwards, this organisation has a very impressive pipeline of products for women's health, Alzheimer's disease, and flu vaccines.

Given the rising long-term demand for healthcare, we believe the outlook for many of these companies is bright. By focusing on companies that are market leaders in their field or offer products for which there is no direct alternative, we believe investors will unlock the strong rewards of medical discovery.

key points

l Healthcare is one of the fastest growing industries in the developed world.

l Many investors assume healthcare investing is just about biotechnology.